We get the big October inflation report tomorrow.

As we’ve discussed over the past week, if inflation continues to go the Fed’s way (i.e. continues to trend lower), the Fed will have to cut rates aggressively next year, otherwise real interest rates (the difference between the Fed Funds rate and inflation) will continue to rise, which will tighten financial conditions even further.

They haven’t acknowledged it.  But it’s obvious.  In fact, UBS said today that they expect the Fed to cut by 275 basis points next year!

So, what does tomorrow’s inflation number look like?  

The consensus view is for a 3.3% year-over-year change.

Remember, a powerful driver of falling inflation (the fall from over 9% to 3%) has been DEFLATION in energy prices.  That said, that deflationary contribution from energy prices should be waning, given supply/demand fundamentals.  But October was a reprieve.

If we look at the price records from the EIA (Energy Information Administration), the year-over-year change across broad energy should be negative for the month of October. 

That should contribute to a slide in October headline inflation from 3.7% (the prior reading).  And that should be welcomed by markets and cheered by the media — more fuel for stocks, and more downward pressure on bond yields. 

And this will come as we already have this bullish trend break across the S&P 500, Nasdaq and DJIA …

And 10-year yields are already trading in the mid-4% area, after failing to break above 5%.

With that, the Fed has a line-up of speakers this week.  We should expect them to curb any enthusiasm.  Remember, they’ve acknowledged that higher longer-term bond yields, lower equity prices, and a strong dollar have “tightened financial conditions significantly.”

But they’ve also made it clear that they want these conditions to persist.   

As we discussed in my Thursday note, the productivity data continue to reflect a productivity boom.

This comes from a tight labor market, as employees are doing more with less, and employers have been forced to innovate/adopt new technologies.  Add to this, we are in the first inning of generative AI, which might be the most productivity enhancing technological advancement of our lifetime.

With that, as we also discussed in my last note, high productivity growth is a driver of long-term potential economic growth. 

Powell gave a speech on it in 2016.  Bernanke, when he was Fed Chair, constantly blamed weak productivity growth as holding back the post-GFC economy.  Yellen did too, during her term, also attributing weak productivity growth to weak wage growth.

Now, here we are, getting the hottest productivity gains since 2007 (excluding the skewed pandemic data).  The Fed should be very pleased.  

But it seems the current Fed Chair, Jerome Powell, is now disinterested.  He barely utters the words.  In fact, scanning back through all of the post-FOMC press conferences this year, he has uttered the word “productivity” a whopping four times.

Why so apathetic?  After all, high productivity growth contributes to economic growth, without stoking inflation.  Remember, the annual growth in the cost per unit of output last quarter was negative!  Productivity gains more than offset wage gains. 

What does it mean? 

It means the Fed should be encouraging dramatic wage gains, to close the gap with the rise in the level of prices over the past three years (to restore living standards).

As Powell has said in the past, wage gains should equal productivity gains plus inflation. 

With that, wages should be growing at double the current 4.2% year-over-year rate.

This is all a formula to recalibrate (higher) the “growth potential” of the economy.  The Fed knows it (well documented through past presentations), yet has in its own projections a long-run economic growth outlook of just 1.8% (the so called “new normal” low growth).

Perhaps this perception manipulation is why the economist and Wall Street forecasts have embarrassingly and dramatically undershot on actual economic growth — and why they continue to chatter about a “slowing economy” if not one teetering toward recession.

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Remember, we are in the early days of what may be the most productivity enhancing technological advancement of our lifetime, in generative AI.

On that note, Q3 productivity data was reported this morning.  And it was big, at 4.7%.  That follows productivity gains of 3.7% (annual rate) in the second quarter.  For perspective, we averaged less than 1% productivity growth for the decade prior to the pandemic.  

These hot productivity gains create the opportunity for the continuation of much needed wage gains (to restore living standards, which have been eroded by inflation). 

On that note, despite some of the hottest wage gains we’ve seen in decades, the annual growth in the cost per unit of output last quarter was actually negative (-0.8%).  This means wage growth is more than being offset by productivity gains. 

That means increasing wages are not a problem in the inflation picture.  And Jerome Powell admitted as much yesterday. 

So, we’re in the early stages of a productivity boom.  That’s great news.  And guess who presented on the importance of productivity growth as a driver of the long-term potential growth rate of the U.S. economy?  Jerome Powell did, back in 2016 (here).

This all supports the path of both economic growth (hot) and inflation (falling).

With the above in mind, we‘ve talked about the reversal signals in the bond market.  With the Fed meeting now behind us, and the increasing likelihood that the next change will be in the direction of interest rate policy, yields continued to slide today.